Jeremy Warner's Outlook: Just what does Debenhams have to offer after private equity takes its four-fold return?

Too much debt puts airports at risk; BA's cut-price fares offer isn't all it seems
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Investors thinking of selling out of BAA at anything less than £10 a share should take one look at Debenhams, which yesterday announced plans to refloat on the stock market, and think again. Little more than two years ago, Debenhams was taken private by a consortium of private equity players which has since managed the business well, if unspectacularly, to deliver a decently sized uplift in sales and earnings.

This might seem reasonably to justify some sort of a premium to the price paid, but whatever risks these people took when they bought the company and however much blood, sweat and tears they have expended on it since scarcely seems to explain the jaw-dropping 400 per cent return private equity will see on its money once the company has successfully been listed again.

How is this possible? How could the company's previous generation of shareholders have been such chumps to sell at such a severe discount to the company's true value, and perhaps more to the point, having sold so cheaply are they really prepared to make themselves look doubly stupid by buying expensively in next month's IPO? The answer to the last of these questions, I regret to say, is probably yes.

As for the first, it's called financial engineering, and it works like this. Baroness, as the private equity consortium called itself, paid approximately £1.9bn for Debenhams back in December 2003, of which £600m was funded by equity and the rest was borrowed from the banks.

Much of this debt was quite quickly paid down by selling freehold stores and leasing them back. The supply chain was also tightened up, releasing working capital, and heavy investment by the previous regime meant that the capital expenditure taps could be turned down to the point where the whole business became a lot more cash generative. The upshot was that Baroness was soon in a position to refinance the business, enabling a £1.3bn dividend payment.

The sponsors now propose to refloat the business on a mid-range market capitalisation of £1.8bn. Of the £900m-worth of shares being sold, £600m will go towards paying down debt and £300m to the present holders of the equity, who for the time being retain a holding worth approximately a further £900m. Hey presto, £600m has come to be worth £2.4bn. Goodness knows what has been taken out on top in financing and advisory fees along the way. All in a day's work for private equity, or to be fair, two and bit years in this case, but then with returns like these who's quarrelling about the time frame?

I don't want to appear churlish about this. Rob Templeman, the chief executive, and his private equity backers deserve their success. They spotted the opportunity, they took the risk, and they managed it brilliantly, but to be frank, I wouldn't much fancy buying what they've now got to sell.

All the physical assets are gone, or mortgaged to the hilt, and it's hard to imagine there's anything further left to be squeezed from efficiency gain or supply chain management. Even after the pay down of debt involved in the IPO, the company remains heavily leveraged. Directors insist there's still considerable opportunity left to grow sales and margin. Believe it if you will. Advisers point to the fact that Debenhams is being floated at a big discount to Marks & Spencer and Next. Well yes, but M&S has lots of property to underwrite its value, and Next has hardly any debt.

Still, the IPO pricing range has been set sufficiently wide to ensure the issue probably gets away. No wonder there's so much money pouring into the private equity houses. You could scarcely ask for a better advertisement of the industry's skills than Debenhams.

Yet it's also going to make investors even more wary than they already are of accepting the private equity shilling, and with ever more money chasing ever fewer reasonably priced opportunities, it is only a matter of time before someone seriously overpays and the private equity alchemists, or rather their backers, end up losing their shirts. All the financial engineering in the world isn't going to help them in those circumstances. Rising interest rates makes the private equity deal too far that much more likely.

Too much debt puts airports at risk

Back to BAA, Britain's biggest airport operator. There was nothing new in Ferrovial's formal offer document for BAA, issued last night, bar one crucial disclosure. Some 65 per cent of the £10.3bn it would cost Ferrovial and its partners to buy BAA under the current terms is made up of debt.

This is a relatively low level of leverage for Ferrovial, which generally gears its infrastructure vehicles even more aggressively, but it is far too high for a company of BAA's importance and complexity, facing as it does a massive up and coming programme of public investment.

Nobody would bat an eyelid if a company like Debenhams went belly up because of excessive debt; if the same thing happened to BAA, it would be a different kettle of fish altogether. Yet if by any chance regulators are persuaded to put the competitiveness of London and the South-east at risk by allowing such a dangerous financial structure to proceed, then the lesson of Debenhams is that shareholders need to be demanding a lot more than Ferrovial is offering. These are assets of unique monopoly value. Nothing less than £10 a share will do.

BA's cut-price fares offer isn't all it seems

"Free" and "cut-price" offers are rarely what they pretend to be, and so it appears at British Airways, which yesterday announced that it is slashing the price of short-haul European fares by up to a half. As with the no-frills operators, it will only be the early birds who catch the really low-price fares. As for late bookers, it seems unlikely they will see any net benefit at all.

What does BA really mean by saying it is cutting one-way fares by up to 50 per cent? Does this apply to every fare as it currently stands? Not likely. In fact, BA will be using the same demand management system to determine prices as has been applied for some years now. The starting fares may be somewhat lower, but as demand builds, it is hard to imagine latecomers will get a similarly bargain-basement price. Indeed, BA expects the initiative to be strongly revenue positive overall, so it seems somewhat disingenuous to claim prices will be falling by a half. They won't be.

That said, it would be wrong to dismiss the whole endeavour as just a marketing gimmick. There are important changes being pushed through here in the way BA sells its product, even if none of them is exactly revolutionary. All BA is doing is applying the model used for many years now by the low-cost operators.

For the first time, it will thus be possible to book one-way tickets easily, and also for a fee to change the time of tickets. Again all BA is doing is applying the system pioneered by the no-frills operators. The change is summed up by the expression: "If you cannot beat them, join them". The only real surprise is that it has taken the company so long to join the 21st century. BA reckons that on average, its short-haul flights are only 70 per cent full. By applying the same system as easyJet and Ryanair, it hopes to fill this spare capacity, thus generating higher revenues from what may be slightly lower fares overall.

For Willie Walsh, there's a bit of gamble involved here - what if cut-price fares fail to fill the spare capacity? - but not much of one. The initiative ought safely to help him on his way towards the target of a 10 per cent operating margin.

As the stock market correctly surmised, the bigger loser is likely to be easyJet, which has made big inroads into the short-haul business market in recent years. Already easyJet can be just as expensive, if not more so, for peak flying times. For many travellers, the opportunity to fly from Heathrow and to get a free drink and snack to boot will be a real advantage. Ryanair, which relies mainly on casual tourist trade and whose prices reflect a tendency to fly to out-of-the-way airports, is unlikely to be affected.